Finance markets struggled in array for most of the week and the condition of European debt crisis remained unclear. Supposedly, we ought to get one thing concrete soon after this Sunday’s EU summit but the hope was dented as a second summit was known as for this Wednesday. Choices would be produced on Wednesday and the summit on Sunday would most possibly be a non-event. Even so, the markets knowledgeable some drastic developments towards to the finish as the speculation of QE3 from Fed suddenly resurfaced. The talk of QE3, as triggered by comments from Fed officials, sent DOW sharply larger to close at 11808, way above the 10404 reduced set in early October. Dollar was offered off across the board and even dived to new record reduced against the Japanese yen. The significance of the improvement is that we’re now probably facing sustainable rally in risks and persistent weakness in dollar ahead.

Fed Governor Daniel Tarullo’s contact for resuming big scale purchases of mortgage backed securities was seriously taken by the markets, probably because Tarullo rarely comments on monetary policy. Fed Vice Chairman Yellen noted that the scale of Fed’s Operation Twist is limited by the quantity of the quick-term securities and buying a big portion of long-term securities “could potentially have adverse effects on market place functioning.” And thus, “securities purchases across a wide spectrum of maturities might turn into suitable if evolving financial situations named for considerably better monetary accommodation.” Chicago Fed Evans named for further stimulus and proposed to carry on until either unemployment falls beneath 7% or medium term inflation outlook rises above 3%. This was agreed by Yellen as “potentially promising”. Boston Fed Rosengren said more asset purchases are “undoubtedly a chance”. St. Louis Fed Bullard also said a third round of quantitative easing was “nonetheless on the table” if circumstances should worsen.

We had much rumors and headlines flying close to about EU summit and the so referred to as extensive package to solve the debt crisis. The messaged were conflicting and confusing. But no matter what politicians and newspapers said, the crucial is, Europeans leaders are nevertheless divided on many troubles, and most importantly, the way to beef up the EFSF bailout fund, bank recapitalization program and how considerably of a write-down to Greek bondholders would be necessary. We will not be speculating on what the outcome would be, as like a lot of of the market participants, we’re tired of hearing rumors all the time. We’re quite confident that absolutely nothing concrete will be delivered on Sunday. For Wednesday? Almost certainly yes, Most likely no. Although, even the selections could be delayed however yet again, we’re quite confident that they would be produced prior to the G20 meeting on November three-4 in Canne. So for the time getting, let’s wait and see and focus on trading the QE3 rumors initial.

Other than Fed’s QE3 speculation, an additional important advancement last week was Japan’s approval of the JPY 12T added spending budget strategy. Amongst that, JPY 2T would be utilized in measures to help the economy contends with a robust yen. The measures are viewed by some analysts as a sign that the Japanese government is increasingly resigned to adapt the economic system to a robust yen, rather than fighting yen’s appreciation. The program also encourages businesses to embrace the strong nevertheless by providing assistance for overseas acquisitions. Also, markets are seeing much less possibility of concerted G7 intervention, like what happened in March. So, a concentrate ahead will be on whether or not USD/JPY would extend the existing decline towards 70 psychological degree and how Japan will react when that occurs.

The Week Ahead

EU summit will carry on to dominate headlines this week. But we speculate that QE3 talks would be the main driving force in the markets. A number of important financial information will be released from US such as Q3 GDP and markets could embrace weak information for escalating chance of QE3. Initially, we believed DOW would face sturdy resistance from 11862 and reverse. But Friday’s sturdy rally instead argues that 11862 would most likely be taken out with ease this week. This will be a main technical concentrate which, when takes place, should trigger deeper selloff in dollar. Also, if risk rally does extend, the primary focus will be on which commodity currency would obtain most. And that would really considerably rely on occasion such as Australia PPI and CPI, RBNZ and NZ CPI, BoC and retail sales. For a lot more on BoC and RBNZ, Each BoC and RBNZ Will Keep on the Sideline.

• Monday: Australia PPI China HSBC PMI Manufacturing Eurozone Flash PMIs New Zealand CPI
• Tuesday: German Gfk client sentiment Canada retail sales, BoC rate choice US S&ampP home price, customer self-assurance
• Wednesday: Australia CPI US sturdy goods, new house sales RBNZ rate selection, NZ trade balance
• Thursday: Japan retail sales, BoJ rate choice German CPI, Eurozone M3 US GDP, pending house sales
• Friday: Japan CPI Swiss KOF US personal earnings and investing

Technical Highlights

The anticipated reversal in DOW didn’t materialize and as a substitute, it managed to stay firm above 55 days EMA and is now moving away from it. Friday’s rally indicates that entire rise from 10404.49 is still in progress and will most likely take out 11862.53 important resistance. In that situation, DOW would likely have a test on 12753.89/12876.00 resistance zone. A break of 11296.12 is necessary to signal reversal or we’ll now remain cautiously bullish.

Dollar index’s fall resumed following consolidation and reached as low as 76.23. 76.06 assistance now looks vulnerable and sustained break there will argue that complete rebound from 72.69 has completed with 3 waves up to 79.838. And in such case, deeper decline would be witnessed to retest 72.69 reduced. Also, the corrective structure of rebound type 72.69 to 79.838 will also suggest that entire down trend from 88.70 is not above yet. In any situation, we’ll now stay cautiously bearish in dollar index as long as 77.552 minor resistance holds.

AUD/NZD’s rebound from 1.2317 extended further last week and remained firm so far. More rise will continue to be in favor and may well target 61.8% retracement of 1.3793 to 1.2317 at 1.3229. However, firstly, the fall from 1.3793 seems impulsive. Secondly, the rebound from 1.2317 seems corrective. That is, rebound from 1.2317 could indeed be a correction only. Hence, although we’re preferring Aussie over Kiwi in near term, we’d be cautious on sudden reversal in strength. And, a break of 1.2700 ought to turn the cross bearish and shift favors back to Kiwi.

AUD/CAD has be bounded in triangle consolidation given that reaching 1.0555 back in June. The rebound from .9937 is impressive so far and could extend additional. But we’d be cautious on reversal as AUD/CAD approaches 1.0516/0555 resistance zone. A break beneath 1.0312 should turn bias back to the downside for one more falling leg within the consolidation pattern. So in quick, Aussie is slightly preferred against both Kiwi and Loonie in near term. But we will not surprise to see Aussie lose strength after the subsequent rise.

USD/JPY eventually had a downside breakout final week and created new record reduced at 75.80 prior to recovering. Some consolidations might be noticed at first this week but recovery ought to be limited by 76.60 minor resistance and bring another fall. Under 75.80 will target 61.8% projection of 80.23 to 75.94 from 77.48 at 74.82 first, and the 100% projection at 73.19. Even though, a break of 76.60 will turn concentrate back to 77.48 resistance rather.

In the larger image, USD/JPY is nevertheless staying well inside the falling channel that started out back in 2007 at 124.13. There is no indication of trend reversal but even even though medium term downside momentum is diminishing with bullish convergence situation in weekly MACD. This kind of down trend is still in favor to carry on to 70 psychological degree. In any case, break of 77.48 resistance is very first essential to indicate completion of fall from 85.51. Secondly, break of 85.51 is necessary to be the initial signal of medium term reversal. Otherwise, we’ll remain bearish in the pair.

In the extended term image, present decline suggests that the long term down trend in USD/JPY is nevertheless in progress. Such down trend is expected to extend further into uncharted territory with 70 psychological level as following target. In any situation, we’d at least want to see sustained break of 85.51 prior to thinking about trend reversal.

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Bank of Canada

Each we and the marketplace anticipate the BOC to hold its policy rate at 1% in October for the 13th consecutive month. The jump in headline inflation in September has probably prevented the central bank to reduce interest rates but it would definitely not trigger a rate hike. We anticipate the central bank will deliver a statement that warns of downside dangers in domestic and international economic outlook.

Headline and core inflation rose in September with the core studying soaring to +2.two% on annual basis, above BOC’s +two% target. But, this unlikely triggers the central bank to tighten monetary policy provided the current headwind facing the worldwide economic outlook. Indeed, BOC governor Mark Carney has stated that he has ‘considerable flexibility’ in how rapidly inflation returns to the central bank’s target. The tolerable sturdy can be extended to as lengthy as 3 many years from 6-eight quarters previously.

Policymakers will also deliver a most current set of economic forecasts following the meeting. As affected by the global economic atmosphere, in specific the US, Canada’s growth will likely be modest in the coming year. Even though the housing market place and the employment scenario have shown improvement, we still assume policymakers will stay cautious in Canada’s prospect and will almost certainly lower its development forecasts from those projected on July 20.

Reserve Bank of New Zealand

Existing industry problems propose that there’s no urgency for the RBNZ to reverse the emergency rate cut adopted in March. Probably moderation in inflationary pressure and continuing deterioration in global financial outlook have diminished the want to a rate hike. The October meeting statement will most likely be much more dovish that the earlier a single as adverse impacts of weakness in US’ recovery and persisting sovereign debt problems in the Eurozone on New Zealand’s trading partners, China and Australia, are finding much more substantial. Regarding monetary stance, policymakers will carry on to adopt a ‘wait and see’ attitude.

Dataflow received for the duration of the intermeeting period was somehow disappointing.GDP grew +.1% in 2Q11, down from +.9% in the prior quarter, as development and manufacturing activities declined far more than expected. While strength in soft commodity exports is expected to help development in coming quarters, fast slowdown in expansion in advanced economies is possessing impacts on New Zealand’s key trading partners in the Asia Pacific region. Whilst it is not the base situation in consensus, if either the US or Europe falls back into recession, New Zealand’s economic system will inevitable got hurt.

Headline inflation climbed +1.% q/q in 2Q11, up from +.8% in the preceding quarter, as driven by higher food and energy rates. Even so, cost pressure should have moderated in the third quarter as worldwide economic momentum has deteriorated. The market expects the upcoming inflation report will display an ease of headline CPI to .five-.7% in 3Q11. This should give the RBNZ extra assistance of leaving the OCR as it is.

Since our last quarterly outlook called ‘Maximum Uncertainty’ the world has moved from bad to worse. Growth prospects have soured and governments and central banks are everywhere pulling out the stops to save the system once again. In Europe, renewed efforts to save the European Union from its debt crisis are foundering as EU politics have reached an all-time low in solidarity and an all-time high in playing to more domestic national agendas.

Policymakers’ efforts in the developed world to salvage the economy with bailouts, stimulus and money printing have failed to build a sustainable recovery since the 2008/09 financial crisis. And yet, have policymakers and central banks learnt anything? Hardly! In fact, it appears they are ready to double down on their previous efforts, a state of affairs we call Maximum Intervention. Top-down analysis suggests that this Keynesian, extend-and-pretend approach of ever more debt creation is likely to result in one of the following three scenarios:

1. Japanisation – continuing to pile ever more debt onto the sovereign balance sheet as the private sector licks its wounds. The analogy is Japan’s lost decades with the question being whether Japan’s unique strong export/strong private sector savings model can ever be repeated elsewhere. Regardless, an overactive public sector that chokes the potential of more private sector dynamism is hardly the path worth taking for other developed nations.
2. Crisis 2.0 – this scenario is triggered by government bond buyers simply going on strike. It appears to be the scariest, but actually offers the fastest and least expensive way to solve the developed economies’ debt dilemma. In a Crisis 2.0, the short term might get very scary in a ‘Lehmanesque’ kind of way on deleveraging and destruction of bad debts through write-offs, etc. Further out, however, unfettered markets and allocation of capital based on gaining the highest marginal return will get the economy going from a healthier starting point and result in far more private sector job creation.
3. Monetisation – This is the favourite choice of policy makers or at least those that feel Japan went in the right direction, but it was simply not aggressive enough. This is the cult of extend-and-pretend – the endless Keynesian game of bailing out, stimulating and printing money while praying that economic growth will miraculously return if we can just buy a bit more time. It also means all governments and central banks will eventually be engaged in QE and weakening their currencies. Look no further than Japan and Switzerland to see how a strengthening currency can trigger unprecedented policy decisions!

In our last Quarterly Outlook, entitled ‘Maximum Uncertainty’, we discussed how uncertain economic and market outcomes might be in the wake of the end of the Fed’s QE2. At the time, we suggested three potential paths that had solid probabilities: 1970s-style stagflation, Crisis 2.0 and QE-to-Infinity.

The 1970s stagflation scenario has ‘died’ as more countries are facing deflation rather than inflation. Still, we do have another theme from the 1970s that remains, namely that of the problems caused by ‘big government’.

That leaves Crisis 2.0 and QE-to-Infinity as the main two scenarios left, with our Monetisation and Japanisation scenarios as two sides of the QE-to-Infinity coin. We feel odds are about even on the two scenarios. Will a Maximum Intervention scenario trigger a true Crisis 2.0 due to a loss of faith in sovereign debt? This would mean an unprecedented (in recent memory, at least) inability for sovereigns to access capital markets. Or do we get QE-to-Infinity, simply the continuation and even expansion of government into more and more sectors of the economy and even our everyday lives?

Politicians in the EU seem to feel that ever more intervention in the market is worth considering as they have proposed – what was once a dead concept – a Tobin tax (a tax on financial transactions).

Meanwhile, the problem and the solution remain pretty simple for the EU – leaders need to stop the half measures and extend-and-pretend schemes and start talking about a true monetary union if they want the EU to survive this critical challenge intact. Let me stress that I am an EU agnostic, but the only way for the EU to survive is through the creation of an EU Ministry of Finance and a common fiscal policy controlled and implemented to make sure that all member countries comply with common sense policies of keeping debt below a threshold and to secure faith in the EU as a trading zone. This would mean one credit risk for investors and trading partners rather than 27 individual bond markets and the related credit risks for each.

Right now, everyone wants to have a liability in the weak countries and assets in the strong, should or rather when the EU breaks up. The flight of capital is depleting and exposing to everyone the dependence on new issuance to pay for old debt. Nowhere is this truer than in Italy and its EUR 1 trn debt market, where political apathy is now resulting in higher yields than normally less favoured countries like Spain.

The entire exercise, started in 2008 at the depth of the crisis, of transferring private stressed debt onto the public balance sheet in order to secure low rates and easier access to capital has failed to sustain a recovery and has reached a saturation point after all of the rounds of debt-finance stimulus and QE money printing to finance much of the debt. At this point, one feels obliged to quote Albert Einstein; ‘the definition of insanity is ‘doing the same thing over and over again and expecting different results’.

That’s the context for the next few quarters: extend-and-pretend remains on the political agenda – and is truly global in scale as we have reached Maximum Intervention. With that as a given, how are we to manage our assets over the coming quarter and beyond?

In the next 18 months we are likely to witness investment opportunities not seen in decades. When and if the game of pretend-and-extend ends, there will be companies, real estate and other assets selling at prices which can only be described as ‘deep value’.

Our approach would be to ‘average into’ risk starting when/if the US S&P 500 breaks below 1050/1100 and then putting five percent of the risk capital into the market each month following this development. This leaves out trying to time the markets and respects the need for the markets to work through a volatile period of uncertainty.

We believe, as suggested by the title of this outlook, that the next three months will see the final desperate moves by policy makers to save the world with more of the same ineffective medicine. We also feel that the market and more importantly the voters are losing faith in the solutions on offer. If they rebel sufficiently, we get Crisis 2.0. And in that case we should be optimistic based on the belief that individuals are more than capable of dealing with a crisis scenario. You only need to think back to your grandparents and great-grandparents: they lived through two world wars, drastically changing political systems and scarcity of all goods and products beyond what most of us can imagine! And yet, they went on to produce the strongest growth and greatest welfare for all levels of society that history has ever known. The future can often look dire when the present doesn’t look so good, but it’s so easy to forget how strongly individuals and companies want to survive and thrive.

Ironically, therefore, we can only hope that politicians’ attempts at maximum intervention fail. Rather than extending and pretending and funding past mistakes (keeping bad debts alive), the focus should be on job creation – and to achieve that, policy should focus on writing off bad debts, encouraging the raising of risk capital and reduction of taxes and regulatory burdens.

Most of the developed countries have become Entitlement Societies where public spending and employment is crowding out the private sector. To change course, we need to hire two persons in the private sector for everyone in the public sector and continue to do so for generations if we’re to get back to the right balance.

The bad news is that a rebalancing will be painful. The good news is Crisis 2.0 is either here or eventually on the way; it will hopefully create visibility for what is needed and why. History tells us that only in times of distress will politicians and policy- makers ultimately take bolder, more rational action. On that note, now more than ever would be the time in which we ponder the true meaning of the word crisis: a turning point, not an extended period of doom and gloom.

Though the world economy will see robust growth of 3.8 percent this year this figure papers over a chasm between developed and emerging countries. While the developed economies led by the heavyweights (U.S. and Eurozone) are struggling to cope with the drag from deleveraging, emerging markets have hiked rates as inflationary pressures have mounted due to strong domestic demand. Domestic demand in emerging countries remains strong and should offset weakening foreign demand from developed economies.

Developed economies struggle to grow amid austerity

What continues to be labelled a banking crisis, in particular now that the Eurozone is on the brink of accepting defeat in the battle for status quo in Greece, is in reality a household balance sheet crisis. The failure to understand the reasons for the global recession and the continued weakness in the major developed countries means that the establishment proposes solutions, which are not going to help much. While we have long championed deleveraging and debt restructuring as the means to quickly revert to a healthy economy, we concede defeat.

Policymakers will not sacrifice short-term pain for long-term gain and are rather bound to repeat in various shapes and forms the erroneous solutions already attempted. These include demands for austerity in countries, which do nothing but push these countries further into recession and hence drive their debt-to-GDP higher, engaging in quantitative easing, and the fine art of kicking the insolvency can further down the road.

The drag from private sector deleveraging will continue for the rest of the year and into next year despite signs of easier credit conditions in some areas of the economy. The austerity-imposed fiscal drag will further undermine wealth in the coming quarters, especially in Europe where a failure to allow both winners and losers has resulted in a game of cat and mouse where the sovereign debt crisis rears its ugly head every few weeks before going back in hiding as policymakers plough money into the fledgling economies as the can is kicked a little bit further.

Given these obstacles, the outlook for growth this year has been and continues to be meagre and with an inventory cycle which has just about run its course, housing markets battling to find a foothold and plenty of excess capacity in labour markets as companies remain cautious, the developed economies are expected to remain in a ‘muddle through’ mode for the rest of this year and into the next.

US: Private sector deleveraging at a slower pace will secure a moderate improvement in consumer spending in Q4 while residential investment remains paralysed by a non-existent housing market. The government spending drag is expected to be mitigated if a stimulus package finds support in Congress.

Eurozone & UK: Austerity will weigh on public spending in Q4 and beyond while private demand will be challenged by a soft labour market. Sovereign debt concerns spreading to Spain and Italy will further undermine consumer confidence and companies’ appetite for investment and hiring.

Japan: The comeback in the second half of the year was not enough to combat the first half weakness due to the March earthquake. GDP is expected to decline 0.6 percent for the year. Net exports are restrained by a strong JPY (at decade high).

Emerging economies: robust growth, but tightening cycle has just about run its course

The emerging economies of the world are a big part of the reason why the global economy will grow robustly in 2011, but there are nevertheless cracks starting to appear. The weaknesses in developed economies are spilling over into emerging economies through softer global trade growth and tighter monetary policy. The tightening cycle began in 2010 in China, India and Brazil in an attempt to fend of domestic inflation while the remaining BRIC-member Russia started tightening earlier this year. With weakness in global trade fighting inflation is no longer the only point on the agenda at the central banks.

The ability of emerging market economies to act swiftly in the face of adversity to bolster private demand by moving towards easier – or just less tight – monetary policy remains a potent weapon and one which is expected to cushion the blow from a further deterioration in global trade growth; though we should not discount the slowdown in manufacturing in some emerging markets as well. Overall, we look for domestic demand to mostly counterbalance a smaller contribution from foreign trade to economic activity in emerging markets.

China: Tighter monetary policy has not made much of a dent in Chinese growth as real interest rates remain low enough to promote speculative behaviour. Meanwhile, net exports and domestic investment are expected to power the economy to 9.4 percent GDP growth in 2011.

Waiting for a US dollar rally this year has felt like Waiting for Godot at times as we anticipated one for a long time before the greenback finally rallied sharply in late August and early September after a long period of stagnation over the summer, despite a number of market developments that have normally proven positive for the currency in the past. Those included falling equity markets, rising signs of worry in other risk indicators and in global growth concerns, particularly in Asia and emerging markets.

In our Q3 FX outlook, we discussed the ‘ugly horse-race’ among the G-10 currencies because we felt that few if any of the major or minor developed economies would offer compelling reasons to buy their currencies and that it would be a question of which currencies appeared the least hobbled by fundamentals. The basic outlines of such a development have come to pass, though the USD was very slow to begin rallying as economic data out of the U.S. was terrible as well. But, the relative slowing in other economies and thus a tightening in interest rate spreads was indeed a positive driver for the eventual USD rally. And because U.S. rates were already so low, the tightening has even occurred despite Federal Reserve Chairman Ben Bernanke’s promise to keep the monetary pedal to the metal on low rates until at least mid 2013 – and despite hints that QE3 in some shape or form is on the way. To take the most pronounced example of falling yield spreads, the highest yielding currency among the G-10, the Australian dollar (overnight rate at 4.75 percent as of mid-September) saw its 2-year government bond yields drop from 4.75 percent at the beginning of Q3 to about 3.50 percent by mid-September, a 125-bp drop as compared with a drop in US 2-year rates of a mere 25 bps or so in the same time frame.

We suspect a further tightening in yield spreads between the USD and other currencies will continue to unwind the carry advantage built up against the USD last year and at the beginning of 2011 as economies around the world, particularly in Europe and to some degree in Asia and in developing markets, stumble through a soft patch in growth or worse. At the same time, yet another round of government stimulus and Fed QE could see a few quarters of solid GDP performance as US politicians pull out all the stops to get the economy going and then jostle to take credit for it ahead of the presidential election next November. Efforts in this direction will be aided by the long period of dollar weakness, which has made the U.S. extremely competitive for sourcing production and services and attractive for investment.

Chart: US 2-year yields vs. average G-10 currency yield. In the chart above we have plotted the spread of the 2-year swap rates for the USD vs. an average of the 2-year swap rates for the remainder of the G10 currencies. We’ve then compared this with the USD’s performance vs. an evenly weighted basket of the remainder of the G10 currencies. It is clear that from a yield perspective, owning the USD is far less unattractive than it was just a few months ago. It is also clear from the chart above that the USD has been slow to respond to this development.

There are two further potential sources of USD strength – one is the likely return of the Homeland Investment Act (HIA), the original version of which allowed U.S. companies to repatriate profits tax free back in 2005. Q4 would appear to be the most likely timeframe to discuss and enact an HIA2, which would then go into effect in the New Year. Estimates of the amounts that might be repatriated this time around are far higher than the original HIA and could reach far over half a trillion dollars.

The other potential source of strength for the USD is that there is simply no alternative in a deleveraging world going where participants are unwinding their previous bets on ‘everything up versus the USD’. The lack of credibility of the Euro as the single currency faces an existential crisis now and in the coming few quarters will also continue to delay the demise of the USD’s status as the world’s reserve currency. Of course, these developments will not boost the U.S. currency forever and we wonder how long it will be until the long run accumulation of the twin U.S. deficits eventually returns to haunt the U.S. debt market and its currency.

Europe – crunch time

As we discuss in our introductory article to this publication, it is crunch time for the European Union, as the efforts of the European Central Bank and EU politicians have failed to outrun the galloping problems caused by the awkward framework of a single currency and 17 finance ministries and 17 sovereign bond markets. As we are leaving Q3, the situation is fast reaching the ultimate crossroads: either the EU makes a strong show of solidarity or a solution will quickly be forced upon it by the markets.

The Euro could see a relief rally if the EU manages to muddle through with the solidarity enforced by the market’s discipline, but a longer term solution to European debt woes would likely involve some form of QE by the ECB to keep bond markets orderly and dig European banks out of their liquidity pinch. And if the USD has been so punished for the Fed’s various rounds of QE, why shouldn’t a similarly dim view be taken of the Euro for also engaging in money printing? Of course, the immediate relief that sovereign debt investments won’t go immediately bad could offset some of the deleterious effects of a European version of QE (save for Greece, where a severe haircut or Greek exit is a question of time). And a more stable sovereign debt and financial services environment could see the Euro rewarded for its deep liquidity versus higher beta, more pro-cyclical currencies as global growth possibly hits a soft patch over the next couple of quarters.

The Scandies – safe havens?

There was a flurry of talk about the potential for NOK and SEK to become safe haven currencies in the wake of the Swiss National Bank’s frantic and so far successful efforts to put a floor in EURCHF at 1.20. Immediately in the wake of the SNB’s announcement in early September, the market drove both NOK and SEK sharply stronger, completely out of proportion to any other development that could have explained the situation besides the idea of safe haven seeking (or reversals based on positioning?). Afterwards, however, the strengthening in these currencies was erased. So are they potential safe havens or not? There are two important features a currency must have in order to be considered a safe haven in today’s environment – a superior sovereign balance sheet and deep liquidity. CHF used to be the best option until the franc’s incredible strength made the SNB and Swiss government ‘go nuclear’ in their intervention. Sweden has a very solid balance sheet and Norway has an impeccable one, but both SEK and NOK fail the liquidity requirement for a true safe haven. Also, SEK is traditionally a pro-cyclical currency due to its economy’s dependence on export markets. NOK is similarly dependent on oil exports, though it tries to sterilise oil revenues with its pension fund. Of the two, NOK would appear a safer harbour than many of the rest of the G-10 currencies, but it would be surprising to see performance similar to the Swiss franc’s (where the oversized Swiss financial industry was an additional contributor to the franc’s aggravated rise).

The Antipodeans: still waiting for the fall

Last time around we asked whether the strength in the Aussie and Kiwi versus the rest of the market was a bit overdone. Both currencies have begun to trade a bit more sideways in Q3, including one particularly sharp sell-off as equities slid off a cliff in early August. The kiwi has been the stronger of the two due to a few months of perkier economic data and the belief that the Reserve Bank of New Zealand might unwind the emergency rate cut taken in the wake of the earthquake earlier this year. But both rather extremely overvalued – particularly the Aussie, given present market circumstances and our expected scenario for Q4. Because Australia has the highest policy rate among the G10 currencies, it also will likely have the highest beta to risk as the Reserve Bank of Australia has more potential for policy accommodation. The housing bubble appears to be in near full deflation phase now Down Under and could cause a considerable pinch in the Australian banking sector, suggesting that eventually even the RBA has to get in on the Maximum Intervention game in the quarters to come.

Chart: AUD and NZD against the rest of the G-10. Aussie and kiwi rose to new multi-year highs against the rest of the major currencies during 2011 and were remarkably resilient despite the heavy sell-off in risk and weakening emerging market currencies. Just before publishing time, however, they suffered a setback in the wake of the FOMC meeting, which may serve as a catalyst that pushes them lower to a fairer value, given the darkening clouds in the global economic outlook and their normal pro-cyclical correlation.

G-10: the bottom lines

USD: A lack of alternatives and Maximum Intervention gone global will make the USD continue to look less unattractive in Q4 and the currency has been so weak for so long that the U.S. economy could reap some of the benefit.

EUR: It is crunch time for the Eurozone, which will need to pull together or face a further – and this time more urgent – existential challenge. Will Germany step up to foot the bill for the periphery?

JPY: The government bond rally and declining interest rate spreads (the carry in the carry trade) are the only real supports, as the domestic Japanese economy is relatively moribund. If bond markets pivot some day, so will the JPY, until then, it could remain strong for a while yet.

GBP: Sterling shows us the degree to which the Euro’s woes are driven by its untenable political and central bank framework rather than by the absolute magnitude of its sovereign debt as the UK debt load and deficits are far worse. Yet, GBP has already been endlessly punished, and similar to the USD, could rally ‘by default’ due to dimmer prospects elsewhere relative to previous expectations.

CHF: The Swiss franc has become the latest, most impressive victim of maximum intervention, which makes the world believe that no fiat currency can be a true safe haven forever. We assume that the determination of the SNB and Swiss Government will keep the CHF weaker.

AUD: Aussie did sell-off when risk appetite swooned in early August, but it is far too resilient given risk averse circumstances, prospects for slower growth in Asia, and on the risk of a disorderly unwinding of the domestic housing market. A heady adjustment lower could finally arrive in Q4 for the Aussie.

CAD: It will continue to trade as an ‘in-betweener’ – a lower beta risk currency that may find resilience in its exposure to a less weak than feared U.S. economy. Still, the currency has only so much upside despite the solidity of the sovereign balance sheet and banks, as Canada features the world’s most overleveraged consumer.

NZD: Some of its strength has derived from economic activity from earthquake rebuilding and some of it from Chinese diversification interest (which throws huge weight around in the less liquid kiwi). The rally could falter in Q4 on weaker than expected Asian growth prospects and as the RBNZ stays pat.

SEK: Likely to remain a pro-cyclical currency – the country could face a slowdown that could be multiplied by a European demand slowdown. In addition, Sweden’s housing market is a raging bubble, though the signs of strain have yet to show much. Could they begin to do so in Q4?

NOK: Rate expectations have tumbled as with most other currencies where there is enough rate to cut. NOK may find a safe harbour bid to a degree due to the country’s unmatched sovereign balance sheet, so strength versus the most pro-cyclical currencies might come into play in Q4 and Q1.

Highlights

• Markets cautiously optimistic on EU summits
• Fed’s QE3 is back on the table
• Bank of Canada and RBNZ decisions next week

Markets cautiously optimistic on EU summits

Major asset markets spent another week see-sawing on headlines emanating from European capitals on the prospects for a credible solution to the debt crisis. They finished out the week nearer to their highs after Germany and France again vowed to find a comprehensive solution. (Recall that markets received a similar boost following the Merkel/Sarkozy summit on Oct. 9 at which they issued similar pledges; EUR/USD gained from below 1.34 to the recent high just above 1.39.) Still EUR/USD spent the week bouncing around in a 1.3650-1.3900 range for the week, signaling markets are waiting for details before reacting with consequence.

The key issue remains the size of the bailout fund – it needs to be large enough to deter speculators from attacking the government debt of larger economies like Italy and Spain – or it’s likely viewed as ‘not credible.’ The latest word is that the short-term bailout fund (EFSF) may be combined with the long-term bailout fund (ESM) for a total capacity of EUR 940 billion, though even that amount is subject to dispute, since EUR 190 bio of the EFSF has already been pledged to Greece, Ireland, and Portugal. Negotiations continue on how best to maximize or leverage the bail-out funds, but a significant impasse remains. The French would like the rescue fund to function as a bank, enabling it to borrow essentially unlimited funds from the ECB, but Germany is adamantly opposed to involving the ECB. Even if the German government were to acquiesce on the issue, it would still need to be approved by the German parliament, which seems even more hostile to the idea. And for its part the ECB has given every indication it will not act as the lender of last resort. Until that is resolved, and it seems likely it may not be next week, national governments will be on the hook to provide additional funding for bank recapitalizations and support for government debt markets. Which raises the question: How credible is it that Italy/Spain/France borrows more to support their own government debt or banking sectors?

We think the answer is ‘not very’ and this suggests to us next week will not see a breakthrough moment, but only another postponement of the day of reckoning. Still, markets have been placated in the past by other ‘kick-the-can-down-the-road’ solutions, at least for a short while. We do think EU leaders will come up with enough concrete plans for bank recapitalizations, Greek debt haircuts, EU governance and other issues to allow markets to make lemonade out of the lemons. (We would note that Greece gained EU/IMF approval for the next aid installment on Friday, another Band-Aid, but short-term positive development.) How long markets continue to give the EU leadership the benefit of the doubt remains to be seen, which is why we remain extremely cautious.

In terms of price indications, EUR/USD has built itself into a clearly defined 1.3650-1.3900 sideways consolidation, with a potential double-top at recent highs around 1.3910/20. We will be especially alert for a range break that is not sustained on daily closing basis, and we think there is potential for continued extreme volatility. Our preference, outlined in the Weekly Strategy, is to buy EUR/USD on weakness below the lower end of this past week’s range. We would also note price is just below the daily Ichimoku cloud, where the base starts next week at 1.3922 and the cloud top at 1.4022 as additional key daily close price levels.

Fed’s QE3 is back on the table

Fed Governor Dan Tarullo (FOMC voter) spoke this past Thursday on the challenges facing the US economy and highlighted the acute unemployment problems facing millions of Americans and the potential for long-term harm to the US economy. In his remarks he raised the possibility of the Fed re-initiating purchases of mortgage-backed bonds (a form of QE3) to spur the housing market and thereby bolster the broader economy. His comments suggest to us that at least some on the FOMC are aware of the risks of doing too little to support economic recovery, which is causing us to keep a more open mind on the potential for QE3 in the near-term. While our central view remains for no policy action from the Fed at the Nov. 1-2 meeting, we are starting to have some second thoughts. In any event, the mere mention of QE3 still appears to elicit a bullish response for risk assets and a bearish reaction by the greenback. We think the broad-based USD weakness seen at the end of the past week was as much to do with the potential for QE3 as on optimism the EU will finally deliver. We will pay close attention to upcoming Fed speakers (and there are several next week) to see if Tarullo’s sense of urgency is shared by more.

Bank of Canada and RBNZ decisions next week

The Bank of Canada is expected to hold rates steady at 1.00% when it announces its policy decision on Tuesday, Oct. 25. We think there is a small risk that the BOC adopts a more dovish response to continued US sluggishness and global uncertainty and eases by 25 bps. We expect the BOC statement to highlight global uncertainty emanating out of Europe and to express confidence that recent increases in CPI are due to temporary factors, maintaining an overall cautious/dovish stance. We think the Loonie will continue to be driven by overall risk sentiment based on European developments. The RBNZ is also expected to remain on hold at 2.50% when it reports on Wednesday afternoon EDT. We think the RBNZ statement will indicate a firm bias to remain on hold, given global uncertainties offsetting ongoing economic recovery.

HIGHLIGHTS OF THE WEEK

United States

• European leaders are meeting in Brussels this weekend to try and come up with a plan to restore market confidence and secure the future of the common currency. But those hoping for a grand bargain are likely to be disappointed.
• The real challenge is deeper than European policymakers have publicly acknowledged: how do you restore confidence in a union of countries that, with few exceptions, are highly indebted and relatively uncompetitive? A successful solution must involve the reform of European institutions themselves, as well as an understanding among member states over the responsibilities they hold to themselves and to each other.
• The U.S. financial system, and the broader economy, will remain at risk as long as doubts linger over Europe’s future. Although the economic recovery has proven stronger than many had feared, the risk is that troubles in Europe throw it off course.

Canada

• Europe’s debt crisis has had a severe impact on Canadian financial markets in recent months.
• In addition to double-digit declines in equity markets and the Loonie, increasing concerns about counterparty risk and contagion effects have led to increased interbank funding costs.
• Fortunately, the escalation in financial volatility has not yet led to significant downgrades to the Candian economic outlook, but a key risk lies in whether or not European leaders can contain the crisis.
• If control is lost, a systemic European banking crisis could spread to Canada and lead to an economic and financial environment similar to that of 2008 during the fall of Lehman Brothers — but unlike 2008, both households and governments are too indebted to spend their way out of a full-scale financial crisis.

A glance at headlines this week and one could be forgiven for thinking that Europe’s fiscal crisis is on the verge of being solved. Today, European policymakers descended on Brussels to begin a series of talks over how to fix the continent’s debt woes. The hope is that leaders can come up with a credible plan to restore market confidence and secure the future of the common currency. But so complex are the problems, and so varied are the ideas that need to be reconciled, that those hoping for a grand bargain are likely to be disappointed.

European leaders face three daunting challenges. First they must figure out what to do about Greece, whose economy is buckling under the weight of draconian austerity measures and social unrest. As we have argued time and again, Greece will have to default. But this creates a second problem: how to fight contagion in bond markets once it does. A Greek default could cause borrowing costs to surge for countries like Italy and Spain, shutting them out of debt markets, and effectively rendering them insolvent. The final challenge, then, is in figuring out how to deal with the banking fallout. For banks with significant holdings of these countries’ bonds, a sharp reduction in the value of those holdings could lead to capital shortfalls. If some banks were to fail as a result, the entire European financial system would come under stress.

If leaders manage to come up with a plan that addresses these issues then financial markets will rally on the news, and Europe will have staved off calamity, at least for a time. But market confidence will likely prove fleeting. That’s because Europe’s problems run much deeper than policymakers are willing to acknowledge. In the end, leaders must restore confidence in a union of countries that, with few exceptions, are both highly indebted and relatively uncompetitive. A successful solution must involve the reform of European institutions themselves, as well as an understanding among member states over the responsibilities they hold to themselves and to each other. This takes time, and time is something markets are increasingly unwilling to give.

The U.S. financial system will remain at risk as long as doubts linger over Europe’s future. American banks held an estimated $ 1.4 trillion in European debt as of March 2011. If the dominos start to fall an ocean away, banks here would surely feel the rumblings.

Unfortunately, the only thing U.S. financial institutions can do is shore up their own balance sheets in preparation for what might come. Already U.S. money market funds have begun aggressively reducing their exposure to European banks. According to Fitch, a ratings agency, the aggregate European exposure of the country’s largest prime money market accounts is at its lowest level since tracking began in 2006.

The good news is that the U.S. economy has proven itself stronger than many had feared just a few months ago. We estimate the economy expanded between 2.5-2.7% in the third quarter, above our initial forecast of 1.9%. Still, the economy faces its own set of domestic problems that will take time to get out from under – a depressed housing market and frustratingly high unemployment chief among them. Although the path to full recovery may be a long one, the economy has managed to keep on trekking. The risk now is that the storm brewing across the Atlantic throws it off course.

Europe’s debt crisis has once again taken center stage this week with continued discussions regarding a (relatively) new plan to save some of its more troubled constituents. For Canada, although trade relations with Europe remain sufficiently small, the two are bound nonetheless by indirect linkages through the world economy and global financial system. Already Europe’s challenges have been key contributors in Canadian financial market volatility in recent months. Selling pressure led to near 20% declines in equity markets worldwide between July and early-October. Ultimately, Canada’s currency is not a safe haven given its smaller, relatively illiquid markets, and thus the Canadian dollar has also taken a hit. The Loonie fell by more than 10 U.S. cents between July and early-October before recovering to its current 97-98 U.S. cent level. Fortunately, a falling currency does help to absorb some of the impact of declines in commodity prices by boosting the competitiveness of the export sector, at least temporarily.

Furthermore, concerns about bank solvency in Europe have impacted Canada’s financial institutions. Though direct exposure to Europe’s banks is limited, increased concerns about counterparty risk and contagion effects have led to higher interbank borrowing costs. The 3-month interbank lending rate stands at 1.23%. Although still a remarkably low cost of funds, it is 11 basis points higher than in August despite broader interest rates having moved lower over that same period. It is this trend that represents a major risk to the Canadian financial system in the event of a full-scale financial crisis. In September 2008, the interbank lending rate spiked by 85 basis points even though the relevant government bond yield fell by 170 basis points.

Fortunately, the escalation in jitters over Europe’s troubles have not been substantial enough to significantly weaken our Canadian growth outlook since our September forecast that calls for modest growth and a 40% recession risk. Indeed, recent data have actually exceeded expectations, most notably in the U.S. economy.

The key risk, however, is if European leaders lose control of the situation and the debt crisis spreads. Risk aversion would almost certainly spike and it is not inconceivable that shades of 2008′s financial turmoil would be seen. The Canadian dollar and equities would be further impacted by such volatility – within a six month period in 2008, the Canadian dollar fell from above parity to 77 U.S. cents, while the S&P/TSX composite lost 45% of its value. In this environment, government bonds and the U.S. dollar would be the only safe havens, as even gold would find it difficult to hold on to its value if fears surged.

Ultimately, a European systemic banking crisis could take many forms and would depend on the response taken. The challenge for Canada is that, unlike in 2008, its economy would not be able to spend its way out if the outlook for the global economy were to sour dramatically. Elevated household debt levels and fiscal deficits would limit both consumer and government spending. None of this is heartwarming. Thus, much is at stake regarding how Europe tackles its challenges. The hope is that European leaders will manage to reach consensus on a plan that marks a major step forward in tackling its crisis.

U.S. Durable Goods Orders – September

• Release Date: October 26, 2011
• August Result: Durable Goods Orders -0.1%; Ex. transportation -0.1%
• TD Forecast: Durable Goods Orders 0.3%; Ex. transportation 0.7%
• Consensus: Durable Goods Orders -0.6%; Ex. transportation 0.5%

Weaker Boeing orders should be the main factor dampening the pace of headline durable goods orders in September, partially offsetting the positive momentum in motor vehicle orders. During the month, we expect the headline durable goods orders to be flat. Excluding transportation, orders should advance by a respectable 0.7% M/M pace, rebounding from the modest decline the month before. Core capital goods orders, a gauge on the tone of capital spending intentions, should also be decent, rising by 1.0% M/M, following a similar gain the month before. In the months ahead, with the economic recovery beginning to gain traction, we expect the pace of orders to accelerate, reflecting the improving tone in overall economic activity and fixed capital investment by US businesses.

U.S. Real GDP – Q3/11

• Release Date: October 27, 2011
• Q2 Result: 1.3% Q/Q
• TD Forecast: 2.5% Q/Q annualized
• Consensus: 2.3% Q/Q annualized

After essentially stalling in the first half of the year, the US economy appears to have regained some momentum in Q3. During the quarter, we expect the economy to boast a more respectable 2.5% Q/Q annualized pace of growth, following the disappointing 1.3% Q/Q advance in the prior quarter. A rebound in consumer spending, and gains in business investment and net trade activity are likely to be the main driving forces behind the advance in economic activity, more than compensating for the weakness in government spending. Given the boost in new residential construction activity, we expect residential investment to also add modestly to the top-line growth, though this is likely to unwind in the subsequent quarter. Much of the momentum in overall activity is likely to be sustained in the last quarter of the year, with GDP expected to moderate slightly to 2.0% Q/Q in Q4.

Canadian Retail Sales – August

• Release Date: October 25, 2011
• July Result: Retail Sales -0.6% M/M; Ex-autos 0.0% M/M
• TD Forecast: Retail Sales 0.5% M/M ; Ex-autos 0.8% M/M
• Consensus: Retail Sales n/a ; Ex-autos n/a

After unexpectedly falling in July, Canadian retail sales are forecast to have increased by a relatively-subdued 0.5% M/M in August. The magnitude of the forecasted rebound is limited by a soft month for employment, an erosion in financial conditions, and the confidence-sapping impact of the stream of negative headlines emanating from the US and Europe. Auto sales were also on the weak side, leaving a sharp increase in existing home sales as one of the only bright spots expected to lift retail sales. As a result, when the auto sector is excluded, we expect to find sales increase by 0.8%. Keep in mind, when set against a fairly large gain in consumer inflation, retail volumes are likely to show a much smaller increase (we are tracking a 0.1% gain) than *Forecast by Rates and FX Strategy Group. For further information, contact TDRates&
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. the nominal series. Looking further into the year, the steady erosion of confidence is expected to keep the pace of consumer spending subdued.

Bank of Canada Interest Rate Decision

• Release Date: October 25, 2011
• Current Rate: 1.00%
• TD Forecast: 1.00%
• Consensus: 1.00%

The realignment of the Bank of Canada’s outlook to a darker and more precarious global economy will be completed next week with the release of the October Monetary Policy Report (MPR). Given the relative optimism expressed in July, this document will carry more weight than usual in helping to flesh out what was previously a qualitative assessment of the impact that the global slowdown and erosion in financial conditions would have on Canadian growth and inflation. Of course, the MPR will come a day after the Bank’s Fixed Announcement Date (FAD) where it is expected that the overnight rate will be left unchanged at 1.00%. Other than providing a preview to the MPR, the communiqué accompanying the FAD is likely to echo many of the sentiments expressed in September and in recent speeches by Bank officials. We expect that the subtly hawkish bias introduced last month will remain in place, suggesting that holding the overnight rate lower for longer is the preferred policy option to contemplating an outright cut.

Neither Doom nor Boom: Moderate Growth Is the Story

• The triumph of thoughtful analysis over hype continues. This week’s data on leading indicators, jobless claims, housing starts and the Philadelphia Fed survey suggest moderate growth ahead.
• Yes, problems do remain – existing home sales – and other problems persistent beyond the expectations (promises?) of policymakers – inflation and high unemployment.
• On balance, the outlook remains for moderate economic growth with the accompanying three problems of housing, employment and government restructuring.

Cyclical Recovery-Structural Drags

This week’s economic data on leading indicators, jobless claims, housing starts and the Philadelphia Fed survey suggest that the cyclical recovery continues even though the pace remains moderate and thereby disappointing to many.

Leading indicators rose 0.2 percent in September and have risen 5.3 percent over the past three months. This pattern is consistent with continued economic expansion – certainly not a recession. The gains in the index were led by financial indicators – money supply and the yield curve – as well as production indicators, such as consumer goods orders and supplier deliveries. Jobless claims continue to drift down, suggesting modest, painfully slow, improvement in the labor market. The four-week moving average for claims has declined for the past several weeks and now stands just above the 400,000 threshold. Housing starts rose in September led by the multifamily segment. This supports our economic outlook that nonresidential construction/apartments would contribute to growth going forward. Finally, on Thursday, the Philadelphia Fed index jumped back into positive territory with a nice gain in new orders, which we view as a leading indicator for the economy.

The weight of this week’s evidence suggests continued moderate growth ahead, with gains of 1.5 percent for the second half of this year and the first half of next year.

Structural Drags

Problems do remain as evidenced by the existing home sales report. Reports of contract cancellations have risen sharply in recent months – 18 percent of National Association of Realtors members reported a cancellation in September. Thirty percent of sales are distressed and prices continue to fall. These issues continue to drag economic growth as losses in household wealth for some households is being recognized and the confidence of other households is undermined.

Meanwhile, the inflation data undermines the real disposable income of households. This week’s consumer price report came in at 3.9 percent year over year, and this surely is a hit to real incomes. As a result, consumer spending in our outlook remains subpar compared to earlier economic recoveries.

This subpar outlook is reinforced by the three problems of housing, employment and government restructuring that has accompanied this recovery. Housing has been a strong contributor to growth in earlier recoveries and yet we expect housing starts to improve slowly, averaging 740,000 next year compared to 610,000 this year. Second, job gains remain far below prior recoveries and we expect job gains to average 100,000 in the year ahead while a typical recovery would average 250,000 mid-cycle. Finally, the restructuring of both the federal and the state-local governments leads us to posit that government purchases will subtract from growth for all of 2012.

Economic activity reflects the influence of cyclical and structural adjustments – unfortunately our adjustments have a ways to go.

Consumer Confidence • Tuesday

The Conference Board’s measure of consumer confidence topped out in this cycle in February at 72 and has been trending down ever since. Indeed, the September reading of 45.4 is below the lowest levels measured in the recession of the early 2000s. Some market watchers have pointed the finger at the congressional standoff over the debate about raising the debt ceiling for the deterioration in sentiment. But given the stubbornly high unemployment rate and stagnant income growth, there is no shortage of explanations.

So far the lack of confidence has not kept shoppers away from the stores. Recent retail sales data confirm growth at department stores and clothing stores during the back-to-school month of September.

We will get the October reading of consumer confidence from the Conference Board on Tuesday.

Previous: 45.4 Wells Fargo: 47.2

Consensus: 46.0

New Home Sales • Wednesday

The 2.3 percent drop in sales of new homes brings the number of monthly declines to four straight – the longest losing streak since 2009. That said, the declines have been rather small. As the nearby chart shows, the annualized rate of new home sales has been on cruise control at roughly 300,000 for the better part of the past year.

To put that number in perspective, consider this: from the Kennedy administration until May 2010, the annualized pace of new home sales never fell below 335,000 in a single month. Since May 2010, the pace of sales has never risen above 335,000. We do not see a catalyst for a meaningful recovery for the beleaguered residential construction market in the near future.

New home sales data for September will print on Wednesday; we expect to see a modest uptick in the month.

Previous: 295K Wells Fargo: 306K

Consensus: 300K

Gross Domestic Product • Thursday

Back in July when we got our first look at GDP figures for the second quarter, we learned that the recession was worse than initially reported and that the recovery was not as far along as we had first been told. We wrote at the time that it was a “game-changing” report and indeed it kicked off a fresh round of speculation about whether or not the U.S. economy was headed for a double dip.

After growing at just a 1.3 percent annualized rate in the second quarter, we suspect that U.S. economic growth likely accelerated to a 2.1 percent rate in the third quarter. The official numbers will hit the wire on Thursday morning. Despite terribly weak consumer sentiment, spending by consumers likely contributed to growth in the quarter as did a faster pace of growth in business fixed investment spending.

Previous: 1.3% Wells Fargo: 2.1%

Consensus: 2.5% (Q/Q Annualized)

Chinese Growth Slows, German Confidence Fades

• Chinese economic growth slowed to 9.1 percent year over year in the third quarter, continuing the slowing trend that started in the second quarter of 2010. The central bank has been raising interest rates and reserve requirements to cool the economy, and it appears that those efforts are paying off.
• Amid slowing economic growth and growing concerns about the European debt crisis, German investor confidence plunged to a three-year low in October. Conflicting reports of progress and division regarding a solution to the crisis have kept markets on edge.

Volatility Continues Amid Dizzying Array of News

Global markets got off to a rough start on Monday, Oct. 17, after German Finance Minister Wolfgang Schaeuble warned that investors should not expect a silver bullet solution to Europe’s debt crisis at the Oct. 23 European Union summit. Investors had been hoping this might be the case after German Chancellor Angela Merkel and French President Nicolas Sarkozy promised on Oct. 9 to unveil a comprehensive plan to tackle the market’s No. 1 ill. Furthermore, Merkel’s spokesman, Steffen Seibert, suggested the search for a resolution would extend well into next year. Adding more anxiety to markets was Moody’s warning of a possible downgrade of France’s credit rating due to “the deterioration in debt metrics and the potential for further contingent liabilities to emerge.”

October 17 also brought the release of China’s third-quarter GDP, which showed growth slowing to 9.1 percent year over year from 9.5 percent in the second quarter. The central bank has been trying to cool the economy by aggressively raising interest rates and bank reserve requirements since late 2010 amid increasing inflation. Inflation has finally begun to ease, slowing for the second straight month in September to 6.1 percent year over year. Ebbing inflation and three straight quarters of moderating economic growth show efforts to engineer a soft landing are paying off.

The same could also be said of China’s efforts to deflate its housing bubble. On Oct. 18, the government reported that 17 cities saw month-over-month declines in new home prices in September, compared to 16 in August. In Wenzhou, prices were even down from a year ago. In addition, in 24 cities that saw price increases, the biggest increase was just 0.3 percent. While the end of an unsustainable surge in Chinese home prices is somewhat good news, it comes at a time when export growth is slowing as China’s important export markets, namely the United States and the Eurozone, are experiencing a drop in demand. Still, since China’s banks are not nearly as exposed to the housing market as were banks in the developed world during the financial meltdown, a Chinese housing slowdown is unlikely to lead to a banking crisis as it did in the developed world.

Despite rising optimism in global markets for a European debt solution, a report on Oct. 18 showed the ZEW Index of German investor confidence plunged in October to -48.3, the lowest since November 2008 (bottom chart). The effects already being felt from the debt crisis, reflected in the weakest economic growth in Germany in the second quarter since the first quarter of 2009, as well as concerns about future effects in the event that the crisis is not contained, have clearly rattled investors. Weak growth and waning investor confidence in Europe’s largest economy do not bode well for the rest of the continent.

Conflicting reports of progress and division regarding a solution to the debt crisis have kept markets volatile. Investors hope that European leaders can agree very soon on Greek debt reduction, capital cushions for banks and an increase in the rescue fund.

Eurozone PMIs • Monday

Business sentiment in the Eurozone has been trending down for the better part of the past year. In August the manufacturing PMI slipped into contraction territory and in September, the services measure followed suit. Our first look at October sentiment is due out on Monday, though the consensus is not expecting much of a rebound in sentiment given the ongoing uncertainty about the debt crisis in Europe and expectations for weaker global growth.

This particular month, financial markets will be less focused on these numbers as they might be in a different month. The reason for that is that these numbers hit the wire the day after the Oct. 23 meeting of European leaders about the debt crisis. For more on what we expect to see there, please turn to page 7 of this report and look at our Topic of the Week which focuses on the next crucial step for European markets.

Previous: Manufacturing: 48.5, Services: 48.8

Consensus: Manufacturing: 48.0, Services: 48.5

Bank of Canada Rate Decision • Tuesday

The Canadian consumer price index came in at 3.1 percent for September, just above the Bank of Canada’s (BoC) target.

Meanwhile, core consumer prices increased by only 0.1 percent during September and remain stable at 2.0 percent on a year-over-year basis. The Bank of Canada has indicated that it expects inflation to decline in the coming months, as higher food and energy prices unwind.

After a weaker-than-expected GDP print for Q2, some market watchers were concerned that a slowdown in Canadian economic growth might increase pressure on the BoC to ease policy somewhat. But generally stronger economic reports in recent weeks, particularly a strong September jobs report, take the notion of any potential easing off the table in our view. The Bank likely will be on hold for the foreseeable future.

Japanese Industrial Production • Friday

After falling off a cliff in March following the tsunami, Japanese industrial production has been steadily coming back on line. Manufacturing output has increased for five straight months. The slower rate of growth is no longer a reflection of supply chain disruptions but rather reflects the pullback in economic activity across the world. September Industrial Production data are due out on Friday of next week.

Third-quarter GDP may be bolstered somewhat by the bounceback in manufacturing activity, even if the growth is not very strong. Japanese real GDP fell at an annualized rate of 2.1 percent in Q2, but we project that growth turned positive again in Q3. A stronger-than-expected number next week could lead to some upward revisions for Japanese GDP growth.

Previous: 0.8%

Consensus: -2.1% (Month-over-Month)

Interest Rate Watch

Ceteris Paribus and Default Risk

Two aspects of financial reporting appear regularly and, unfortunately, are very misleading to investors and decision makers.

First, there is a tendency to associate a movement in one economic variable with the movement or lack thereof of another to suggest cause and effect. The latest misconstruction appeared this week with the argument that perhaps Operation Twist was working because the 30-year Treasury rate rose in value. Huh? Yes, that was our response.

Operation Twist was suppose to lower the long end of the yield curve not raise the 30-year yield, so the premise of the article is all wrong. More importantly, the article fails to appreciate the importance of ceteris paribus – all else held constant.

While the Federal Reserve was discussing Operation Twist, something else more important was happening – market expectations on the economy were changing. In particular, the outlook was becoming less negative as retail sales, employment and, most recently this week, the Philadelphia Fed index all were better than market expectations. From our viewpoint, it was this change in economic expectations that altered the path of long-term rates and most likely obscured any impact from Operation Twist.

Treasury Debt Is Not Risk Free

Unfortunately, U.S. Treasury debt is not risk free, as is frequently asserted in both written and televised commentary. Treasury debt may be default-risk free but for anyone familiar with the history of credit markets from the 1970s on Treasury debt is very risk-full due to the uncertainties of inflation, currency and therefore interest rate fluctuations.

Inflation destroys the real return on Treasuries, and with consumer prices rising at 3%+, the real value of the return on Treasuries is negative – a very risky proposition. Dollar depreciation is a risk for foreign investors. The experience of 1994-1995 is a dramatic example of interest rate risk. Today’s low Treasury rates are a bet on many factors – not just default.

Credit Market Insights

State Budgets Reflect Balance

After a summer of contentious political wrangling over state budgets there is some light at the end of the tunnel for those states that made the tough choice of deeply cutting expenditures. The balance between slower revenue growth and public spending has returned to many states. The budget reforms and fiscal policy actions in light of more conservative revenue forecasting and budget cuts has setup many states for a much better fiscal year ahead. New data indicate that state tax collections are increasing and, in some cases, exceeding originally forecasted estimates. While the rebound in state revenues is welcomed news, there is still a long way to go before states fully return to the revenue growth experienced before the recession. As a result of revenues exceeding forecasted amounts, state budget shortfalls will likely be much lower in the 2013 state fiscal year, which for most states begins next July. The National Conference of State Legislatures estimates that state budget gaps should fall to around $ 31.9 billion for fiscal year 2013, down from $ 91.0 billion in the current 2012 fiscal year. While much improved from previous years, there are ongoing risks to state budgets as the federal government prepares its plans to cut spending that will likely further affect state budgets in the next cycle. But the fact that states have managed to strike a new balance between spending and revenues should benefit these governments in the form of lower borrowing costs in the future.

Come Monday, Will It Be Alright?

The sovereign debt problem in Europe has evolved from an “issue” on the periphery to a front and center “crisis.” This weekend, European leaders are getting together for what seems to be the highest stakes meeting yet to address the crisis. It is not yet clear what they will discuss, but leaks to the media suggest an itinerary that will focus primarily on a recapitalization of the banking system and devising a way to lever the assets set aside in the European Financial Stability Facility (EFSF). So, heading into this crucial meeting, we lay out what to watch for in terms of an outcome. We would add however, that full details of the meeting may not be available until the middle of next week.

The moving parts here are the number of systemic banks that would be recapitalized and what capital ratio would be used. An IMF report suggested a package of this magnitude might cost €200 billion-€250 billion, but some of the details leaked to the press suggest a package of €100 billion, which may disappoint financial markets.

The second consideration is the extent to which European leaders agree to lever the newly expanded EFSF. With some of the €440 billion already pledged, the EFSF can only do so much good in its present form. But the fund could cover more assets if it secured only a specified percentage of the amount covered. Instead of purchasing government bonds of troubled Euro-member states outright in the secondary market, EFSF funds could be used to provide partial guarantees through a “first loss” insurance plan. Covering first losses up to 25 percent of face value, for example, could enable €250 billion of EFSF funds to cover €1 trillion of bonds. It is not yet clear whether or not that will be enough to calm markets.

The final factor is the northern European economies will want to make sure the Greeks and other ESFS recipients feel the pain in terms of accepting necessary austerity measures. This will likely include more labor reform as well as raising the retirement age. Considering the riots in Greece, these measures are sure to face opposition.